Corporate Tax Reform and S-Corps

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Karen M. Kroll

Tue, 2013-08-20 13:27

The attention being paid to tax reform has centered on the challenges facing C-corporations, such as the fact that the U.S. corporate tax rate is higher than most other countries’ rates. As a result, the impact of changes on S-corporations and other pass-through business organizations can be overlooked.

S-corporations pay the highest effective tax rate of any type of business structure, according to a new study, “Entity Choice and Effective Tax Rates,” by the S Corporation Association and the National Federation of Independent Businesses. In fact, the S-corp tax rate, at 31.6 percent, is more than double the 15.1 percent rate of sole proprietorships, the study found. And, the results hold even when the taxes paid on C-corporation dividends are included, the study found.

The findings are key for several reasons. For starters, elected officials currently are focused on tax reform. Indeed, that was the genesis of the website, https://taxreform.gov, developed by Senate Finance Committee chair Max Baucus and House Ways and Means committee chair, Dave Camp. The two, who’ve held more than 50 hearings on the topic, also tweet at @simplertaxes.

However, the attention being paid to tax reform often has centered on the challenges facing C-corporations, such as the fact that the U.S.’ statutory corporate tax rate is higher than most other countries’ rates. As a result, the impact of changes on S-corporations and other pass-through business organizations can be overlooked. (Pass-through entities, as the title indicates, pass business profits through to their owners, who then include the profits earned on their individual returns.)

Moreover, a growing number of business owners are choosing S corporations as their business structure. A 2010 GAO report found that while S-corporations accounted for just 12.6 percent of businesses in 2006, that was up 35 percent from 2000. Also, S-corporations are the most common type of corporate structure, accounting for 61.9 percent of corporate tax returns in 2003, according to the IRS.

While S-corporations continue to be popular, several legislative changes over the past few years have resulted in a top marginal rate for individuals and pass-through businesses of 44.7 percent. This number includes both the top individual tax rate of 39.6 percent on taxable household income of $425,001 or more, as well as the net investment income tax (NIIT) of 3.8 percent, which was part of the Affordable Care Act. The NIIT comes into play on investment income above certain thresholds.

This compares to the current 35 percent top marginal tax rate for C-corporations with taxable income of more than $10 million.

While the higher top marginal rate is important, it’s the effective tax rate that matters most. As noted above, S-corporations don’t do as well as C-corporations in this regard, either. Several reasons account for this. One, of course, is the higher individual tax rates. In addition, with a pass-through structure, taxpayers are taxed on all their income, not just the income from a business. That means a modestly profitable business may lead to a higher marginal tax rate for the taxpayer if he or she has significant other income.

One thing the S-corporation tax structure does provide, as the study notes, is progressivity. The smallest S-corporations pay taxes at an effective rate of 19.2 percent. This gradually increases to a rate of 35 percent for those with net income of $200,000 or more.

In contrast, the effective tax rates for all other types of business structures, while generally progressive, include some outliers. For instance, C-corporations with between $10,000 and $25,000 in net income pay at a rate of 33 percent, while those with incomes of $2.5 million or more pay at a rate of 15.5 percent.

Indeed, the Main Street Alliance, a network of small business coalitions, says the study “leads to the conclusion that the goal of tax reform must be to correct unfairness in the U.S. tax code by requiring large corporations to pay their fair share.”

It seems the most effective reform would include all these changes: limiting the deductions that allow the largest companies to pay effective tax rates that are a fraction of their statutory rates, while also looking at the corporate and individual tax structures together, so that those choosing to operate as a pass-through entity aren’t penalized.